Download ECON 521 Special Topics in Economic Policy

ECON 521
Special Topics in Economic Policy
CHAPTER FOUR
Fiscal Policy and the
Budget
I. Overview
• The government is to stable the economy.
• Stabilization is through Government intervention role
by manipulating the public budget to increase output
and employment or reduce inflation.
• Fiscal Policy – the government changing its budget
position (G - T) in order to stabilize the economy.
• Fiscal Policy, by its nature, alters the Budget
Example; The US Federal Budget: 2003
(Billions of Dollars)
Tax Revenues
Gov. Expenditure
Federal Budget
$1974.8
$2381.3
-$406.5
Note: Source: Economic Indicators, October 2005.
II. The Budget and The Budget Position
•
•
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•
•
•
Budget = T - G
Budget Position (or size of deficit) = G – T
Budget < 0 -- Budget Deficit
Budget > 0 -- Budget Surplus
Budget = 0 -- Balanced Budget
Realistic Goal -- Balanced Budget when
Y = YN
• The National Debt –
- The total accumulated stock of debt owed by the
government to its lenders (holders of government
bonds).
- Expanded by budget deficits, reduced by budget
surpluses.
- Debt-Income Ratio = (National Debt)/(GDP)
Example;
For the US in 2004 =
( $4295.5)/($11734.3) = 0.366
For the US in 2010 =
• The Income Tax and the Budget
Y*  Tax Revenues  T  (T - G)
A strong and growing economy improves the budget.
Y*  Tax Revenues  T  (T - G)
A weak economy generates a lower budget.
• The Income Tax and Automatic Stabilization
Automatic Stabilization -- due to the income
tax system, tax revenues change in directions
that help to stabilize the economy, without any
change in the tax structure (i.e. fiscal policy).
III. Fiscal Policy Implications
(1)Strategy of Fiscal Policy
• Expansionary policies seek to induce more
purchasing of goods and services by increasing
(G - T) -- i.e. G or T.
• Contractionary policies seek to induce less
purchasing of goods and services by decreasing (G T) -- i.e. G or T.
(2) Fiscal Policy in the AD-AS Model
• Expansionary Fiscal Policy shifts the AD curve
rightward, increases Y* and P*.
• Contractionary Fiscal Policy shifts the AD curve
leftward, decreases Y* and P*.
(3) Fiscal Policy Options
Policy options: G or T?
- Economists tend to favor higher G during recessions
and higher taxes during inflationary times if they are
concerned about unmet social needs or infrastructure.
- Others tend to favor lower T for recessions and lower
G during inflationary periods when they think
government is too large and inefficient.
IV. Automatic Stabilization
Y* (maybe > YN)  Tax Revenues
helps to cool the economy
Y* (maybe < YN)  Tax Revenues
helps to stimulate the economy
Note -- all this takes place without any change in the tax
structure, as prescribed by fiscal policy.
As a result;
• The size of automatic stability depends on responsiveness of
changes in taxes to changes in GDP: The more progressive the
tax system, the greater the economy’s built-in stability.
• In Figure 1 line T is steepest with a progressive tax system.
• The U.S. tax system reduces business fluctuations by as much
as 8 to 10 percent of the change in GDP that would otherwise
occur.
• Automatic stability reduces instability, but does not eliminate
economic instability.
Figure 1; Built-In Stability
Government Expenses, G
and Tax Revenues, T
T
Surplus
G
Deficit
GDP1 GDP2
GDP3
Real Domestic Output, GDP
V. Obstacles to Fiscal Policy Effectiveness
• Difficulties in getting the proper policy passed
through General Assembly.
• A tax cut that isn’t used for spending. AD curve does
not shift rightward, no change in Y*.
• Worries about the Budget within a sluggish economy.
• Time lag between changing the policy and its impact
on the economy
VI. Other Complication to Fiscal Policy
Effectiveness
(1) The Crowding Out Effect -- An Adverse “Side
Effect”
The Crowding Out Effect -- Expansionary fiscal
policy creates an increased need for more borrowing
by the government. This financing increases the
demand for financial capital. As a result, long-term
interest rates (r*) rise and Investment (I*) decreases.
(2)The Crowding Out Effect -- Fiscal Policy
Effectiveness
• Crowding Out Effect -- makes fiscal policy less
effective than would be otherwise.
• Decrease in investment to some extent offsets rise in
(G - T).
• Smaller shift in AD curve than would be without the
crowding out effect.
(3)The Crowding Out Effect – Impeding Economic
Growth
• Crowding Out Effect  loss of Investment (I).
• Decrease in Investment retards the buildup of the
capital stock and possible implementation of new
technology (i.e. Labor Productivity growth).
• Smaller shifts in LAS curve, smaller increases in YN.
NOTE;
Ways to Avoid the Crowding Out Effect
Bottom line -- get the supply of financial capital
to shift rightward at the same time as when
expansionary fiscal policy occurs.